Conditional portfolio allocation: Does aggregate market liquidity matter?

This paper investigates how aggregate liquidity influences optimal portfolio allocations across
various US characteristic portfolios. We consider short-term allocation problems, with single
and multiple risky assets, and use the nonparametric approach of Brandt (1999) to directly express
optimal portfolio weights as functions of aggregate liquidity shocks. We find, first, that
the effect of aggregate liquidity is positive and decreasing with the investment horizon. Second,
at daily and weekly horizons, this effect is weaker on allocations in large stocks and gets stronger
as we move toward small stocks, regardless of the other stock characteristics, suggesting
that liquidity is the main concern of very short-term investors. Third, conditional allocations
in risky assets decrease and exhibit shifts toward more liquid assets as aggregate liquidity
worsens. Overall, conditioning on aggregate liquidity yields empirical results that are consistent
with the so-called flight-to-safety and flight-to-liquidity episodes. Finally, we propose a simple
tactical investment strategy and show how aggregate liquidity information can be exploited to
enhance the out-of-sample performance of long-term strategies.